Definition of invoice financing: what is it and how does it work?

Invoice Financing Explained

Every company needs cash to fund its operations — to pay for materials, distribution, rent, and payroll, to name just a few necessities. Companies with bank loans or lines of credit can take advantage of them during periods of slow cash flow. But companies that need cash quickly or can’t secure a traditional bank loan sometimes turn to receivables financing. In receivables financing, a financial company extends a loan to a business based on revenues earned but not yet collected. For some companies, the cash they receive — often within a day or two of entering into a financing arrangement with a financial company — can provide essential liquidity until they have a more comfortable cash cushion.

Invoice financing works best for B2B sellers that have well-known customers with reliable payment histories. Retail, manufacturing, and agriculture companies are among the types of businesses that often turn to invoice financing as a financing mechanism. Invoice financing isn’t an option for companies that primarily sell to consumers or whose payment model is cash-and-carry.

How Does Invoice Financing Work?

An invoice financing arrangement involves three parties: the business that issues an invoice, the customer that receives the invoice, and the financial services company. To get the maximum benefit from this type of receivables financing, a business must negotiate terms with the financing company and hope that its customer pays by the due date on the invoice — or earlier.

How is invoice financing structured?

Invoice financing arrangements have some similarities to short-term loans. In its simplest form, invoice financing would be based on a single invoice, or account receivable. With that invoice serving as collateral, a financial company operating as the lender advances cash to the business that owns the invoice. When the business gets paid, the business sends the original loan amount back to the financial company, along with interest based on the length of time the loan has been outstanding.

How much does invoice financing cost?

Invoice financing is not an inexpensive way to raise capital. A financial company providing cash to a business under this arrangement will typically charge both a single-digit processing fee and a weekly factor fee, also in the single digits. Because of the weekly assessment of the factoring fee — so-called because such lenders are themselves known as “factors” — even a low factor fee can result in an annual percentage rate (APR) of 25%, 35%, 50%, or even more.

To understand the economics, consider a hypothetical urban design firm looking to raise cash against a $50,000 invoice. A financial company agrees to advance the design firm 80% of the invoice value, or $40,000. In return, the design firm will pay a 0.5% processing fee and a 1.5% weekly factor fee on the cash outstanding. The design firm’s customer pays in four weeks, allowing the design firm to send the financial company the original $40,000 it borrowed plus the $200 processing fee and $2,400 it owes as a factor fee — or $2,600 altogether. The design firm nets $47,400 of its $50,000 invoice.

Types of accounts receivable financing

If a company has known customers with good credit, its accounts receivable can be used to generate capital during periods of slow cash flow. There are three main types of accounts receivable financing:

• Invoice financing. In this arrangement, a company approaches a finance company for a cash advance against one or more outstanding invoices. The cash advance may be for the full value of the invoice, although it is usually somewhat less.
• Invoice factoring. This is similar to invoice financing as a way to collect an invoice prior to payment. However, in invoice factoring, a factoring company purchases the invoice and assumes responsibility for collecting payment from the customer.
• Accounts receivable-based line of credit. This is a line of credit that companies can obtain using their accounts receivable as collateral. The financial terms are usually more favorable than the terms available through invoice financing or factoring. However, in many cases, the dollar volume of invoices required to obtain the line of credit is too high for smaller companies.

Invoice factoring

Invoice factoring is similar to invoice financing in that both are mechanisms for obtaining cash quickly, and often the same finance companies offer both types of financing. However, in invoice factoring, the finance company actually purchases the invoice from a company and assumes responsibility for collection. This has the advantage of relieving companies of time-consuming collection efforts. That said, it also involves the risk of ceding control of an important customer interaction to a third party.

Accounts receivable line of credit

This is another type of accounts receivable financing that works like a bank line of credit, but with a company’s unpaid invoices as collateral. It can be set up so that the company pays interest only on the money it borrows. However, it can be difficult to qualify for AR lines of credit. Lenders generally require a long-term commitment and a substantial dollar volume of invoices, neither of which is usually an option for early-stage companies.

Pros and cons of invoice financing

Invoice financing can be immensely valuable to businesses, allowing them to continue operating during periods of limited cash flow and to pursue opportunities that can turn their fortunes around. But it also has some drawbacks. Management teams should understand both sides before deciding whether to use invoice financing.

Pros: Invoice financing offers three main benefits that are especially useful for growing companies, which may face certain challenges due to their early stage of development and limited resources.

• Easy money. In certain businesses, it is not unusual for companies to be flying high from a sales and profit perspective but struggle with cash flow. Invoice financing allows B2B companies to get cash up front, sometimes within 24 hours, on revenue, they have earned but not yet collected. In these circumstances, invoice financing can reduce an owner’s cash flow and allow management teams to continue important initiatives that they would otherwise have to abandon.
• Very valuable in the event of an emergency. Natural disasters resulting in damaged inventory, an outage involving a key supplier, or the bankruptcy of a key customer – developments like these can quickly put companies into survival mode. If a company is facing one of these existential threats and doesn’t have much cash in the bank, the quick cash provided by invoice financing can save the company.
• Relatively simple approval processes. Many young and growing companies do not have the credit qualifications necessary to obtain bank loans and lines of credit. This does not matter as much to companies that provide invoice financing because they are more concerned about the credit rating of the company’s customers than the business itself. A company that requests a cash advance on its invoices will generally face less paperwork and fewer questions.

Cons: Against these advantages, companies should consider the three main disadvantages of invoice financing:

• High cost. Invoice financing is a relatively expensive way to raise capital. Processing fees and weekly interest rates, or factors, can generate APRs that are multiples of what a company would normally pay for a bank loan.
• The unpredictability of the ultimate cost. It’s not just that invoice financing is more expensive than many traditional forms of financing. A related problem is that when entering into an invoice financing arrangement, a company generally does not know what its final cost will be. The final cost often depends on how quickly a customer pays the invoice. A delay in payment longer than contracted for can negate any gain from a sale.
• Limited applicability. Not all companies can use invoice financing. For its use to make sense, a company must be in a B2B industry. It must also have customers with excellent credit ratings and a history of on-time payments.